Here is Tim Fernholz responding to my earlier worries about resolution authority as expressed in the Dodd bill. My first worry was that the $50 billion dollar fund wouldn’t be enough to handle resoluton:

Next, there is a $50 billion insurance fund that will come from money assessed from banks based on the amount of risk that they carry. This is the banks’ “skin in the game,” and it is the first money that will be spent in the case of liquidation. It is primarily intended to allow the receiver to maintain the operations of the company while its assets are parceled out in order to avoid a fire sale. This does not necessarily entail paying off counter-parties but rather will allow them to hold various contracts, like the AIG derivatives, by posting margin rather than simply paying off their full value.

But that’s not all the money there is — Mike is rightly worried that the Fund is too small, and that’s where the next step of receivership comes in. The legislation allows the FDIC to assess the institution and then borrow up to 90 percent of the FDIC’s valuation of its unsecured assets — not whatever numbers the bank has on the books — from the Treasury in order to complete the receivership. Finally, there is a post-event mechanism to recoup any losses, similar to but more narrowly structured than the president’s TARP recovery tax. On the whole, my sources say, the process has many similarities to a Chapter 7 liquidation — management and shareholders are wiped out, and bondholders will get similar treatment to a bankruptcy; they will not, I was told, get 100 cents on the dollar.

But at the moment we’d need to lean on this fund the most is during the moment at which a firm being resolved assets are worthless or have been pledged as collateral to secured creditors. By definition the firm is worthless when the assets don’t meet its obligations – I can’t imagine borrowing 90% of what is left over in the crater of a Lehman would be enough.

And if the fund is very likely to be exhausted and net negative value, the other systemically risky firms left over from a Lehman crash will have to repay into it. But this will probably happen in a weak market, and a giant new obligation on their balance sheet will weaken them further, creating more systemic risk.

Obama’s team have mounted a giant campaign to win the financial reform argument. I’d really like to see some sort of study by Treasury or GAO or anyone credible on how this Dodd bill would have worked on Lehman, and how it would have worked on Citi. Costs, implementation, etc. Health care had all kinds of work done on each sliver of the bill. I understand the argument that the cross-border stuff has to be handled through the G-20, and I wish everyone good luck with that. But even within this more narrow framework I get worried about how robust this mechanism is without more structural changes to derivatives and asset sizes.

What a Living Will Should Look Like

I also said I didn’t think living wills were enough. Tim:

One other note on this: While funeral plans, which would require big financial companies to maintain strategies for winding down their firms, are certainly not the be-all end-all of the Dodd bill, they’re not quite as weak as Mike characterizes them — while they are certainly still ripe for gaming, they’re not just whatever the company wants to write and submit. Regulators will need to approve these plans well in advance and work with the banks to ensure they meet specific standards, or else they can make changes to the company. This also forces more accountability on regulators, who won’t be able to claim they didn’t discuss winding down a firm until it was too late.

Both Greg Mankiw and Alan Greenspan are excited about this new living will feature, so I should probably address my worries here more strongly and targeted.

If we want to use analogies, a living will is really an “organ donor card.” If the ambulance gets there fast enough, you can harvest all the stuff checked off, be it a heart, eyes, etc. If the regulators are able to move fast enough, they can take certain assets and have a feel how they would be sold. That falls under the resolution bucket, and it is by definition the last step. What we also want are roadmaps that come into play earlier, during a detection phase or during a prompt corrective action phase.

What I want to see in the bill is something more like a “monthly fire drill.” I had to do them as a kid at school, why don’t the banks have to as well? Something required where firms draw up how they would respond to a stress event, say a run on the shadow banking sector or a freakout in the money market funds, especially in terms of regaining capital. Another thing I would like to see required are plans for how they would derisk their firms if a prompt corrective action/early remediation was triggered. This way, when worries are tripped, there’s at least some prior thought as to how to go about winding down the firm in a least-cost manner, or how to bring the firm back online. The living will seems to be a post-mortem affair; what we really want to see is a set of plans for the 6-12 months leading up to the resolution.

There should be special emphasis on international information sharing, which has problems on free-riding, and on more frequently updated information. But changing the timeframe for observation from the day after a crisis to the 6 months before would really help regulators. I draw this from Paul Tucker, Deputy Governor at the Bank of England, who writes well on these topics. The crisis management menu (my bold):

Firms themselves need to play a leading role in drawing up “recovery plans”. At least two components are needed, roughly corresponding to liquidity and capital. First, a contingency
funding plan (CFP). Too few banks of any size seem to have had one in any serious way. There was, for example, too little focus on the effects of ratings downgrades on collateral calls and on the availability of lines of credit. And too little attention was paid to core liquidity holdings: a treasury portfolio comprising the FRNs issued by other banks does not leave a distressed bank with many options in the face of system-wide stress. Banks need to know exactly what assets they hold in which securities-depository systems; how long it would take to deploy them; and which are eligible in which central banks’ routine facilities. Too few banks had that information readily to hand. Maybe they do now. They should.

Second and beyond liquidity planning, recovery can involve derisking. This might mean laying off risk, shedding positions or even selling businesses. Once in distress, banks absolutely must be prepared to shrink their franchise in order to sustain themselves. That may entail having businesses set up within groups in a way that would facilitate sale, if necessary. Sometimes what a group regards as its core franchise will not map exactly into what the authorities think of as the essential economic services it provides. That is obviously for discussion between firms and their regulators, who need to be ready to exercise powers to force risk-reduction and recapitalisation where necessary to preserve the soundness of the enterprise and the stability of the system.

“Derisking” is all about the capital resources of banks in the face of idiosyncratic or widespread stress. There is, therefore, a read across from the “Living Wills” exercise to the question of how much capital banks should hold. Almost no amount of capital is enough if things are bad enough.

(These may be fighting words, but my secret advice: listen to British people about banking. American economists who study finance post-1970 spend half their time thinking about how awesomely efficient the financial markets are – ketchup economists unite! – and whether or not there could even be a limit to arbitrage since financial markets are so awesome, or they use game theory on corporate finance. The British take banking really seriously, in a tradition going back to Bagehot and including people like Hawtrey and Keynes.)

Regulators could ask for these, and people at large systemically risky financial firms could make them anyway. But if they are anything like me, they are lazy and won’t do it unless forced to by the law. And if you are thinking of ways of making the financial reform bill better in an easy way, this is low hanging fruit.